10-1

Credit Analysis

10
CHAPTER
 10-2

Credit Analysis

Liquidity &
Working Capital Solvency
Liquidity Ratio

1: Cash Based
2: Acc. Receivable Earning
Consideration
3: Inventory Turnover Coverage
4:Current liabilities
5: Acc. Payable
6: Assets Composition
Application 7: Acid Ratio
 10-3

Credit Analysis

Liquidity &
Working Capital
 10-4

Liquidity and Working Capital

Basics
• Liquidity - Ability to convert assets into cash or to obtain
cash to meet short-term obligations.
• Short-term - Conventionally viewed as a period up
to one year.
• Working Capital - The excess of current assets over
current liabilities.

Lack of liquidity can limit: Severe illiquidity often precedes:

Advantages of discounts Lower profitability
Profitable opportunities Restricted opportunities
Management actions Loss of owner control
Coverage of current obligations Loss of capital investment
Insolvency and bankruptcy
 10-5

Credit Analysis

Liquidity &
Working Capital

Consideration
 10-6

Credit Analysis

Liquidity &
Working Capital

Consideration

Application
 10-7

Liquidity and Working Capital

• Comparative Analysis
– Trend analysis
• Ratio Management (window dressing)
– Toward close of a period, management will occasionally press the
collection of receivables, reduce inventory below normal levels, and
delay normal purchases.
• Rule of Thumb Analysis (2:1)
– Current ratio above 2:1 - superior coverage of current liabilities (but not
too high - inefficient resource use and reduced returns)
– Current ratio below 2:1 - deficient coverage of current liabilities
• Note of caution
– Quality of current assets and the composition of current liabilities are
more important in evaluating the current ratio.
– Working capital requirements vary with industry conditions and the
length of a company’s net trade cycle.
 Liquidity and Working Capital – Net Trade 10-8

Cycle ? Assignment
• Net Trade Cycle Analysis
Illustration
Selected information from Technology Resources for the end of Year 1:
Sales for Year 1 $360,000
Receivables 40,000
Inventories* 50,000
Accounts payable† 20,000 Then, the net trade cycle is computed as:
Cost of goods sold (including depreciation of $30,000) 320,000

*Beginning inventory is $100,000.

†These relate to purchases included in cost of goods sold.

We estimate Technology Resources’ purchases per day as:

Ending inventory $ 50,000
Cost of goods sold 320,000
370,000
Less: Beginning inventory (100,000)
Cost of goods purchased and manufactured 270,000
Less: Depreciation in cost of goods sold (30,000)
Purchases $240,000
Purchases per day = $240,000/360 = $666.67
 10-9

Credit Analysis

Liquidity &
Working Capital
Liquidity Ratio

1: Cash Based
2: Acc. Receivable
Consideration
3: Inventory Turnover
4:Current liabilities
5: Acc. Payable
6: Assets Composition
Application 7: Acid Ratio
 10-10

Liquidity and Working Capital

Cash-Based Ratio Measures of Liquidity
• Cash to Current Assets Ratio
Cash + Cash equivalents + Marketable securities
Current Assets
– Larger the ratio, the more liquid are current assets

• Cash to Current Liabilities Ratio

Cash + Cash equivalents + Marketable securities
Current Liabilities
– Larger the ratio, the more cash available to pay current
obligations
 10-11

Operating Activity Analysis of Liquidity

Accounts Receivable Liquidity Measures

• Accounts Receivable Turnover

• Days’ Sales in Receivables

• Receivables collection period

 10-12

Operating Activity Analysis of Liquidity

Interpretation of Receivables Liquidity Measures

• Accounts receivable turnover rates and

collection periods are usefully compared with
industry averages or with credit terms.
• Ratio Calculation: Gross or Net?
• Trend Analysis
– Collection period over time.
– Observing the relation between the provision for
doubtful accounts and gross accounts receivable.
 10-13

Operating Activity Analysis of Liquidity

Inventory Turnover Measures

• Inventory turnover ratio:

– Measures the average rate of speed at which inventories

move through and out of a company.

• Days’ Sales in Inventory:

Illustration (Day’s sales in inventory)
– Shows the number of days required to sell ending inventory

• An alternative measure - Days to sell inventory ratio:

 10-14

Operating Activity Analysis of Liquidity

Interpreting Inventory Turnover

– Quality of inventory
– Decreasing inventory turnover
• Analyze if decrease is due to inventory buildup in
anticipation of sales increases, contractual commitments,
increasing prices, work stoppages, inventory shortages, or
other legitimate reason.
– Inventory management
– Effective inventory management increases inventory
turnover.
 10-15

Operating Activity Analysis of Liquidity

Interpreting Inventory Turnover

– Conversion period or
operating cycle:

• Measure of the speed

with which inventory is
converted to cash
 10-16

Operating Activity Analysis of Liquidity

Liquidity of Current Liabilities

• Current liabilities are important in computing working
capital and current ratio:
– Used in determining whether sufficient margin of safety exists.
– Deducted from current assets in arriving at working capital.

• Quality of Current Liabilities

– Must be judged on their degree of urgency in payment
– Must be aware of unrecorded liabilities having a claim on
current funds
 10-17

Operating Activity Analysis of Liquidity

Days’ Purchases in Accounts Payable

• Days’ Purchases in Accounts Payable

– Measures the extent accounts payable represent

current and not overdue obligations.
• Accounts Payable Turnover

– Indicates the speed at which a company pays for

purchases on account.
 10-18

Additional Liquidity Measures

Current Assets Composition
– Indicator of working capital liquidity

Illustration
Texas Electric’s current assets along with their common-size percentages
are reproduced below for Years 1 and 2:
Cash $ 30,000 30 % $ 20,000 20 %
Accounts receivable 40,000 40 30,000 30
Inventories 30,000 30 50,000 50 %
Total current assets $100,000 100 % $100,000 100

An analysis of Texas Electric’s common-size percentages reveals a marked

deterioration in current asset liquidity in Year 2 relative to Year 1. This is
evidenced by a 10% decline for both cash and accounts receivable.
 10-19

Additional Liquidity Measures

• Acid-Test (Quick) Ratio - A more stringent test of
liquidity

• Cash Flow Measures

– Cash Flow Ratio

– Overcomes the static nature of the current ratio since its

numerator reflects a flow variable.
 10-20

Credit Analysis

Liquidity &
Working Capital Solvency
Liquidity Ratio

1: Cash Based
2: Acc. Receivable
Consideration
3: Inventory Turnover
4:Current liabilities
5: Acc. Payable
6: Assets Composition
Application 7: Acid Ratio
 10-21

Basics of Solvency
• Solvency — long-run financial viability and its ability to
cover long-term obligations
• Capital structure — financing sources and their
attributes
• Earning power — recurring ability to generate cash from
operations
• Loan covenants — protection against insolvency and
financial distress; they define default (and the legal
remedies available when it occurs) to allow the
opportunity to collect on a loan before severe distress
 10-22

Basics of Solvency
Financial Leverage- Illustrating Tax Deductibility of Interest
 10-23

Capital Structure Composition and Solvency

Capital Structure Ratios

• Total Debt to Total Capital Ratio
– Comprehensive measure of the relation between total debt and
total capital
– Also called Total debt ratio
• Total Debt to Equity Capital
• Long-Term Debt to Equity Capital
– Measures the relation of LT debt to equity capital.
– Commonly referred to as the debt to equity ratio.
• Short-Term Debt to Total Debt
– Indicator of enterprise reliance on short-term financing.
– Usually subject to frequent changes in interest rates.
 10-24

Capital Structure Composition and Solvency

Interpretation of Capital Structure Measures

• Capital structure measures serve as screening

devices.
• Further analysis required if debt is a significant
part of capitalization.
 10-25

Credit Analysis

Liquidity &
Working Capital Solvency
Liquidity Ratio

1: Cash Based
2: Acc. Receivable
Consideration Earning
3: Inventory Turnover
Coverage
4:Current liabilities
5: Acc. Payable
6: Assets Composition
Application 7: Acid Ratio
 10-26

Earnings Coverage
Earnings to Fixed Charges
• Limitation of capital structure measures - inability to
focus on availability of cash flows to service debt.
• Role of earnings coverage, or earning power, as the
source of interest and principal repayments.
• Earnings to fixed charges ratio
 10-27

Earnings Coverage
Times Interest Earned

• Times interest earned ratio

– Considers interest as the only fixed charge needing
earnings coverage:

– Numerator sometimes referred to as earnings before

interest and taxes, or EBIT.
– Potentially misleading and not as effective an analysis
tool as the earnings to fixed charges ratio.
 10-28

Earnings Coverage

Relation of Cash Flow to Fixed Charges

• Cash flow to fixed charges ratio
– Computed using cash from operations rather than
earnings in the numerator of the earnings to fixed
charges ratio.
 10-29

Earnings Coverage

Earnings Coverage of Preferred Dividends

• Earnings coverage of preferred dividends ratio
– Computation must include in fixed charges all expenditures
taking precedence over preferred dividends.
– Since preferred dividends are not tax deductible, after-tax
income must be used to cover them.
 10-30

Earnings Coverage
Interpreting Earnings Coverage
– Earnings coverage measures provide insight into the
ability of a company to meet its fixed charges
– High correlation between earnings-coverage
measures and default rate on debt
– Earnings variability and persistence is important

Question
10th
Page 575
Problem 10-1 (a&b):
Additional information besides
text book
information/requirement
1) Acc payable balance at end of
Year 9 is $550
2) Require compute debt to
equity ratio
Page 578
Problem 10-6 (a&b):
Additional information besides
text book
information/requirement
1) Acc receivable balance at end
of Year 4 is $10,000
1) Acc inventory balance at end
of Year 4 is $32,000
1) Acc payable balance at end of
Year 4 is $30,000
Discuss five Airline industry
10-31
11st
Page 591
Problem 10-1 (a&b):
Additional information besides text
book information/requirement
1) Acc payable balance at end of
Year 9 is $550
2) Require compute debt to equity
ratio
Page 594
Problem 10-6 (a&b):
Additional information besides text
book information/requirement
1) Acc receivable balance at end of
Year 4 is $10,000
1) Acc inventory balance at end of
Year 4 is $32,000
1) Acc payable balance at end of
Year 4 is $30,000
Discuss five Airline industry
financial ratio indicators